SMU Political-Economic Exchange

AN SMU ECONOMICS INTELLIGENCE CLUB PRODUCTION - An Evaluation of the Chinese Economy - Hong Kongs Poverty Line What does it entail? - The Economics of Crime: Gangs in El Salvador
The Fortnight In Brief (30th September to 13th October) US: The inexorable march to default? As the US government shutdown looks to enter its third week, negotiations to reopen government have been m erged with plans to raise the debt ceiling which is expected to be reached on Oct 17. While the House has passed numerous spending bills to restore financing for specific portions of the federal government, President Obama and the Senate has stood firm, rejecting all piecemeal bills that do not fully restore funding with a clean continuing resolution. Support has been coalescing behind a previously rejected bipartisan plan, led by Sen. Collins, that would fund the government for 6 months and raise the debt limit through Jan 31. A NBC/WSJ poll shows Republican approval ratings down to 24%, with 53% placing the blame squarely on Republicans, and 31% on the president. Asia: China experiences import surge and export wane China imported 25.68m tonnes of crude oil, equivalent to 6.47m b arrels a day in September. setting a record and overtaking the US to become the top oil importer. China's total imports increased by a stronger than expected 7.4% in September, while exports dipped 0.3% compared with September last year. The increase in imports underscores China's economic growth has firmed following fears of a hard landing. At the same time, analysts worry that the decrease in exports is a sign of a global recovery slowing. EU: Upbeat data reinforce positive sentiment Eurozone industrial production was revised to a 1.0% increase in the month of August, up 2.0% from July. This compares favourably with a 2.1% fall in the same month last year, indicating that the 17 country currency bloc is reversing its 18 month long economic downturn. Germany, France and Italy contribute to approximately two thirds of Eurozone industrial product. Capital goods production also benefited from rising consumer sentiment, rising 2.4% in August after a 1.8% the prior m onth. Despite upbeat economic indicators and sentiment, the recovery is still widely considered to be in its nascent stages as countries suffer from austerity and record unemployment rates.

ISSUE 47 14 October 2013

IN COLLABORATION WITH

PROUDLY SUPPORTED BY
MSCI AC Asia Ex. Japan

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An Evaluation of the Chinese Economy

By Cheng Hao, Singapore Management University
Introduction This article points out the general situation of the Chinese economy today. It focuses on two parts: 1. Chinas monetary policy and its effect on economic system, and 2. the risk due to exchange rate appreciation. There is no single concrete solution for these big questions as economic policy is similar to a double edge sword. However, it is not to say that we should just let the economy adjust itself. Rather, governments should aim to find suitable solutions for the short run, and realize what the major risks are in long run. Chinese Monetary Policy Soft Landing In the first half of 2013, with global quantitative easing, about 2 billion in hot money flooded into the Chinese market during January to April this year, causing the PBOC to increase its M2 balance by the money multiplier. China has since issued 13 billion basic currencies to absorb the hot money. Hot money accounted for 27% of the increase of M2 currency balance in the first half of 2013. The growth rate of M2 balance was 8.5% in the first half, which was not high by historical levels. However, since growth of GDP has slowed down since 2010, we can see the gap between M2 growth rate and GDP growth rate increase in 2013. Figure 1: GDP vs M2 growth
30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% -5.00% -10.00% difference between M2 growth and GDP growth M2 growth GDP growth

From Figure 1, we can see M2 balance rapidly increased in 2008 while the GDP growth rate dropped around 7 percent per year. There are two key factors that fueled the divergence between M2 growth rate and GDP growth rate the stability of the real economic situation and maintenance of liquidity in financial markets. 2 Copyright 2013 SMU Economics Intelligence Club

The Chinese government wants the GDP growth rate to be slowed down in long-run. However, the rapid slowdown will have negative impacts on the economy. Especially after financial crisis, a slowdown the will further damage local demand. Local financial markets serve as a liquidity platform for the corporate system, if corporations encounter liquidity problems, the financial market will suffer losses due to credit risk. Increasing M2 supply can mitigate this situation in short run and allow the domestic economy to avoid a hard landing. Since 2010, the gap between M2 growth and GDP growth has started to decrease. Why M2? M2 equals to M1 plus saving accounts and money market accounts. 90% of Chinas M2 come from banks saving account. The money in the saving accounts can be transformed into liquid money, which is lent to non-financial institutions, governments and individuals. Hence, the M2 balance can be used to indirectly measure the extent of leverage in an economy. Developed countries are able to pay debts relatively better than developing countries as they have a mature financial system with enough capital stock. Developed countries which have a high M2/GDP ratio can still handle their financial situations better compared to an emerging country having the same level of M2/GDP ratio. Total Social Financing Another measurement for total credit size is called total social financing. Total social financing consists of foreign investment, trade account, corporate bonds, structured products and trust financing etc. The credit products it includes are more than that of M2. In addition, statistics show that the growth of TSF (around 30%) is much faster than printing speed (around 5%). However, M2 is measured as a stock value, but TSF is measured as a flow value. The total amount of TSF has been increasing continuously from 2002, but appears to be slowing down in 2013. See Figure 2. Figure 2: Total Social Financing
30000 25000 20000 15000 10000 5000 1/1/2002 8/1/2002 3/1/2003 5/1/2004 7/1/2005 4/1/2007 1/1/2009 8/1/2009 3/1/2010 5/1/2011 7/1/2012 10/1/2003 12/1/2004 11/1/2007 10/1/2010 -5000 12/1/2011 2/1/2006 9/1/2006 6/1/2008 2/1/2013 0

Shadow Banking Starting to Shrink? According to S&P, shadow banking accounts for RMB22.9 trillion of credit in China. It represents 44% of Chinas GDP in 2012. Shadow banking has grown at a compounded annual 3 Copyright 2012 SMU Economics Intelligence Club

growth rate of 34% since the end of 2010. The reason for Chinese banks participating in shadow banking activities is regulatory arbitrage, which indicates that market competition has encouraged banks to seek loopholes in regulations by making loans and attracting deposits via wealth management products and other unconventional channels. However, from 2013, the shadow banking system started to shrink. See Figure 3. The main reason for the decrease is because of a decrease in both traditional bank loans and nontraditional lending as regulators tightened lending rules and clamped down on wealth- management products that channel funds to trusts. Figure 3: Total Social Financing (in 2013)
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Admittedly, the shadow banking problem cannot be solved unless Chinese government can develop a healthy way to increase domestic demand. But it is safe to say that the shadow banking system has not destabilized Chinas financial system. There are three factors that fuel the expansion: (1) The size of shadow banking is still modest relative to the regular banking system; (2) There are many risk characteristics of various shadow banking products; (3) The structure of loss for banks position. In general, the major Chinese banks capitalization, earning, and liquidity profiles provide a comfortable buffer to absorb any possible hit from shadow banking and credit risk to the wider Chinese economy. Implication on Real Estate Market and Fixed asset investments The increase of STF has pushed up the fixed asset investments. Most funds are in short term but they invested in long-term assets such as real estate. This duration mismatching has caused a short-term liquidity problem. As in the past, problems in the real estate market has always impacted the real economy. The surge in demand drove housing prices in 70 major cities up in the first half of the year. Limiting purchase orders did not have that much of an effect. More importantly, personal debt financing increased about 20% compared to last year. The increase of STF pushes up house price and also increased the investment in infrastructure. Land prices have surged due to the real estate bubble. Governments also use their land as collateral via shadow banking to do the off-balance sheet financing. The high lands price incentivize infrastructure investing. 4 Copyright 2013 SMU Economics Intelligence Club

Exchange Rate Risks Exchange Rate Appreciation The short-term capital inflow has increased the exchange rate (see Figure 4) of Chinese Yuan relative to US dollar. Worth of notice is that in 2008, China was forced to appreciate their currency to support the world economy. This time round, we should be worried about the profit earned by foreign investments because with the high nominal interest and high foreign exchange rate expectation, the purchasing power parity and interest rate parity no longer holds, creating an arbitrage opportunity. Figure 4: Exchange Rate (CNY/USD)
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Drawback 1: Local product sales hurt The PPI provides insight why the CNY is appreciating too fast (Figure 5). The reason that we use PPI to observe the side-effect of CNY appreciation is that appreciation hurts the sale of local product, resulting in negative impacts on the job market and other economic areas. The producer price index measures the selling price received by the local producer. The index is constructed on a basket of all tradable goods. If CNY appreciate too much in the short-run, the PPI will decrease correspondingly. Figure 5: Producer Price Index
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Copyright 2012 SMU Economics Intelligence Club

Drawback 2: Decreased Exports The appreciation of CNY will not only hurt the domestic economy in the short-run, but also put stress on exports. The export price index decreased when the CNY appreciated. Figure 6: Export Price Index
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Drawback 3: High Interest Rates Even though the Chinese government can control foreign capital flows, it is only an effective instrument in the short-run. The foreign fund flow will still enter into the country in the long term due to the high domestic interest rates. Hence, in long run, both the banking system and corporate system suffers due to high interest rates. According to the interest rate parity, it is necessary for China to decrease their local interest rate if exchange does not appreciate. The Banking System The high interest rate is likely to become an obstacle for liquidity in banking system. Unlike in the past, the Chinese government wants the interest rate to be determined by the market demand and supply. Admittedly, interest rate liberalization can enhance market efficiency, however, it is hard to say whether medium size banks and financial institutions can handle this market determined rate in the event of a liquidity shortage. History is proof - in mid-June, the liquidity problem of Chinese banking system drove the interbank over-night borrowing rate to 30%, a level unheard of in the past. Such high rates is not something that many medium sized institutions can handle on their own. While interest rate liberalization is needed, perhaps now is not the right time. Conclusion There is no concrete solution for many of these issues. Chinas real estate market has faced big problems, and its potential impact on the real economy makes this a precarious situation. While people may not be worried now, no one really knows where the next crisis lurks. Moreover, with its more opened economy, China is even more vulnerable to external shocks to its economic stability. Thus, we should not assume that all is well and good.

6 Copyright 2013 SMU Economics Intelligence Club

Hong Kongs Poverty Line What does it entail?

By Koh Kang Liang, Singapore Management University
Hong Kongs recent introduction of a poverty line has attracted widespread attention from the region. With some 20% of its population of seven million officially in poverty, this demonstrates economic inequality undoubtedly exists even in developed nations. What will this mean for this East Asian financial centre and a member of Asias four tigers of the 1980s? To put things in perspective, Hong Kongs GDP per capita (at current prices) stands at $36,800. Its Gini coefficient1, a quantitative measure of income inequality using the Lorenz Method, has a value categorised as high, at 0.537 as of 2012. Economic inequality has always been one of the key economic problems for the government. Fundamentally, governments are responsible not just for the provision of economic growth, but an inclusive one as well. After all, in lobbying against perceived government inaction on mitigating a widening income gap, critics ask, Why take care of people if you take care of just a few? Besides political reasons, there is sufficient economic logic to close the income gap too. Income inequality, while inevitable, shows the lack of distributive ability (and hence government inefficiency and/or failure) in a modern day government operating on fiscal functions and tools. Though the poverty line is largely an analytical tool, it may be perceived as an instrument to put pressure on various government departments to narrow the income gap. The following statistics on inequality have emerged, and the results raise some concern: Figure 1: Hong Kong Poverty Thresholds by Household Size

They translates to 19.6% of the population falling beneath the poverty threshold2, indicating the high level of economic inequality and widening income gap within Asias financial hub. With such startling statistics, the Hong Kong government can no longer afford to ignore the plight of its poor, residents of shanty towns obscured by the faade of success portrayed bythe glistening skyscrapers of its financial district. 7 Copyright 2012 SMU Economics Intelligence Club

Government action We have discussed amply about the pressing concern of closing the income gap and bringing the poverty level down. Governments have to ensure economic growth is inclusive and avoids creating a large disparity in standards of living. This applies not just in in Hong Kong but Honduras, Haiti or any other country. Achieving this, however, is the primary bane of the modern-day capitalist system. Economists and governments have been racking their heads to solve the problem and the poverty line is an intelligent yet simple diagnostic. In Hong Kongs case, the government has declared, along with the revealing of these figures, the following action plans: Providing financial help via the Comprehensive Social Security Assistance (CSSA), a system of income supplements and grants for the less advantaged, to help those still in need. This will lift 294,000 people (4.4%) in 111,000 households out of poverty. Further policy intervention costing $14.8 billion (an average of $3,100 per household) might be used to alleviate poverty for the remaining 1,018,000 people. Added focus on employment: providing work incentives, rechanneling of resources, and educational support for juveniles in these households. Most importantly, recognise that the poverty line has its limitations and devise sound policies to attain its economic goals. The final point is of considerable importance. While the poverty line may be a concise measure of inequality, an over emphasis on it may lead to policy hazards or, in some cases, sending the wrong political messages (which is of course not deliberate but inherently committed by data). Figure 2: Hong Kong government expenditure and Inflation Rate, 2005 to 2012
25 Govt expenditure ($ bn) 20 15 10 5 0 2005 2006 2007 2008 2009 2010 2011 2012 6% 5% 4% 3% 2% 1% 0% Inflation rate (%)

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Ideally, we want to move away from these expensive mitigation methods to developing sustainable solutions to the problem in the long run. The fiscal approach easy, concise, and immediate will allow poverty to be eradicated in a rather hassle free manner (at least for the current year). However, spending some $15 billion per year would mean eroding about 2% of Hong Kongs current reserves, and should not be used as a long term policy to address the 8 Copyright 2013 SMU Economics Intelligence Club

issue. From a Keynesian viewpoint, supply side policy (productivity and capacity improvement teaching a man how to fish) must not be ignored, it should be pursued alongside the governments fiscal redistributive mechanism. It is hence comforting to read that the government has placed an emphasis on the employability of the working poor. While we cannot expect Nordic style income equality (average Gini index of 0.254), Hong Kongs Asian neighbours can provide useful case-studies. Learning from the successes and policy missteps in its peers such as Singapore and China (provincial level) is pivotal to ensuring Hong Kongs effort at equality goes well. The antidote for the Hong Kong Government may be found in promoting economic knowledge and looking at the policies of other economies, and eventually combining them in a manner applicable to the local context. For instance the Hukou system on the mainland provides a solution for distribution, though it may be a tad too regimental for Hong Kong. While Singapore academic Lim Chong Yah prescribes a wage shock3 policy his country, Hong Kong may be able to practice discriminatory price shocks in response to its high costs of living (especially home loans) such as distributing food coupons as with the American system.
1 Gini coefficient

An index commonly used to depict quantitatively the distribution of income in an economy. It is mathematically derived by the Lorenz curve (developed by Max Lorenz in 1905), and obtaining a value of 0 we have perfect income distribution (all people have the same amount of wealth); while a value of 1 implies that all the money is held by just one individual. While common in usage, there are intrinsic limitations to using it, both qualitatively and mathematically. 2 Poverty threshold A certain income level determined by the government, and citizens, falling below which, are considered statutorily to be in poverty. It may be defined as per-person or per- household. Just like the Gini coefficient, there are inherent limitations to this analysis tool as well. 3 Wage shock An uncommon policy used to enhance income equality in modern day capitalistic economic systems. This generally involves imposing a minimum wage, freezing the pay at the top percentiles (usually by setting a cap or proportional deduction), or a mixture of both. A highly left-wing policy, it is seldom used, largely for political reasons. Sources: 1. World Bank Database online. Retrieved October 10, 2013. URL: http://data.worldbank.org 2. Yun, M., September 28, 2013. Hong Kongs First Poverty Line Puts One-Fifth of People in Need (Bloomberg News online). Retrieved October 9, 2013. Source URL: http://www.bloomberg.com/news/2013-09-28/hong-kong-s-first-poverty-line-puts-one- fifth-of-people-in-need.html

9 Copyright 2012 SMU Economics Intelligence Club

3. News.gov.hk, September 28, 2013. Poverty line set for HK (Hong Kong government website) Retrieved October 9, 2013. Source URL: http://www.news.gov.hk/en/categories/health/html/2013/09/20130927_191059.shtml 4. To be eligible for the CSSA, residents must pass financial tests set by the Social Welfare Department. Payments are categorised into Standard, Supplements and Grants. Further information: http://www.swd.gov.hk/en/index/site_pubsvc/page_socsecu/sub_comprehens/ 5. Hong Kongs reserves stand at $722 billion as at 30 June 2013. Source: info.gov.hk. URL: http://www.info.gov.hk/gia/general/201307/31/P201307310417.htm 6. The number is the mean of the Gini coefficients of Sweden, Denmark, Norway, and Finland. Data extracted from World Bank Database. URL: http://data.worldbank.org 7. Tan, A., October 25, 2012. Lim Chong Yah unveils Shock Therapy II (The Business Times). Retrieved October 11, 2013. Source URL: http://www3.ntu.edu.sg/CorpComms2/Documents/2012/10_Oct/BTonline_121025_Lim %20Chong%20Yah%20unveils%20_Shock%20Therapy%20II.pdf 8. The Hukou system mandates that every household is on the government register, and subsequently stratifies them by socio-economic status. In our context, the register may be used to identify those who need further help, apart from CSSA eligibility and the poverty line already in place.

10 Copyright 2013 SMU Economics Intelligence Club

The Economics of Crime: Gangs in El Salvador

By Kamini Devi Naidu, Singapore Management University
In El Salvador, crime is controlled by two dominant gangs - Mala Salvatrucha (MS-13) and Barrio 18 (M18). With the homicide rate at 66 homicides per 100,000 inhabitants (second highest in the world after Honduras) in 2010 according to a UN report, the government has been struggling to implement the right set of policies to curb gang violence. In 2003, the government instituted the Plan Mano Dura (the Iron Fist Plan), where severe tactics were used to arrest and imprison suspected gang members based on their appearance. The use of hard security policies did not do the trick as the concentration of gang members in prison was an opportunity to reorganize and regroup. After almost a decade, a soft security measure was tried. On March 9, 2012, a secret brokering of a gang truce led by the government and the Catholic Church between MS-13 and M18 was agreed (Cawley, 2013). Though initially promising, as daily homicide numbers plummeted from 14 to five, effects were transient. Since June 2013, killings have been on the rise again along with other disturbing trends such as a rise in extortion and disappearances. Clearly, policymakers have been unable to get it right. The government adopted reactionary policy measures when it should have adopted a proactive stance. In comprehending what the required resources and incentives to deter criminal activities are, a useful guide for these policymakers to implement effective policies would be the economic theory of crime. The Economics of Crime The economic theory of crime developed by Gary Becker provides a framework for politicians and law enforcement officers to answer rudimentary questions: How much crime will occur? How do we stop criminals from committing crimes? What should be the form and severity of punishments? To answer these questions, Becker developed what is now known as the principal-agent problem. The principal-agent approach has proved to be a productive way of understanding outcomes in a number of relationships in which a person or group (the principal) sets incentives to which another person or group (the agent) responds (Akerlof & Yellen, 2013). In crime, the agent is the criminal whose offenses are an optimal response to the incentives set by the principal the government (who also determines the penalties imposed). Becker looks at criminals as rational individuals, just like ordinary citizens who seek to maximise their own well-being, but through illegal instead of legal means (Bahrani, 2012). Potential criminals would rationally weigh the expected costs and benefits of breaking the rules. If the probability of being caught or the level of punishment is low, the expected costs might be outweighed by the benefits, providing little incentives for these criminals to behave in the interest of the government (R.D, 2012). Thus, understanding how criminals weigh the costs and benefits of incentives and punishments would be a useful starting point for El Salvadorian policymakers. Highway to Hell: The Deadly Gangs of El Salvador Gangs in El Salvador have little incentive to repent. As they control crime in El Salvador, it is unlikely that they will lose control of that power anytime soon. The vertical growth of homicides, extortions, kidnapping and disappearances even after hard and soft security measures have been utilised, indicate that the government (principal) has done little to 11 Copyright 2012 SMU Economics Intelligence Club

incentivise the criminal (agent) to not engage in illicit activities. The government instead has accumulated huge costs in terms of maintaining overcrowded prisoners, increasing manpower and surveillance. Security in El Salvador is further fettered by institutional weaknesses including corruption and opaque legislative processes. Given that the truce terms of agreement are unclear, the lack of transparency does not formally hold any of these gang members accountable. Further, this nebulous truce highlights that these gangs have power even within the political arena. For instance, on the eve of the truce, gang leaders threatened to unleash their members to disrupt local elections. The government instead of using enforcement methods, balked and transferred them to the medium security prisons where contact with the outside is made more possible (Dudley, 2013). Using the economic theory of crime here, these gang members have little incentives to behave in the interest of the government. The crumbling of the truce indicates that current incentives are insufficient, underlining the inability of the government to deter crime. Costs are clearly outweighed by benefits for these criminals as through the truce, they have been able to gain more political muscle. Being thrown into jails too (Iron Fist Plan) will not deter clandestine activities from ensuing as though imprisoned, gangs are often consolidated and many of the street gangs now effectively command from inside prisons (Cawley, 2013). Hence, institutional weaknesses of the government play a role in exacerbating gang violence. Resolving the issue of gang violence in El Salvador requires more than just state policies. The government should invest more in youth development to reintegrate youths into the employment sector as well as create a safer milieu for citizens. By assuring citizens that they can place their trust in the police, community cooperation can help deter crime. A critical deterrent to crime is not an active police presence but instead the presence of knowledgeable civilians, prepared to report crimes and cooperate in police investigation (Akerlof & Yellen, 2013). Reforms at the institutional level should also be ensured. Punitive punishments should be imposed on officials who are corrupt and ensure these punishments are monitored and enforced. Admittedly, changes will occur at a glacial pace, but at least El Salvador will be on the right track. Conclusion The economic theory of crime is a useful economic model to be applied to non-market social structures. Where governments face a deadlock in alleviating social problems, such as gang violence in El Salvador, these models can be useful in understanding why these problems persist and what are the necessary incentives needed to bring change. Being one of the most murderous countries in the world, it is imperative that control of crime shifts from the gangs to the government. Sources: 1. Akerlof, G., & Yellen, J. L. (2013). Gang Behavior, Law Enforcement, and Community Values . Brookings Institution. 2. Bahrani, M. (2012). The economics of crime with Gary Becker. The Chicago Maroon. 3. Cawley, M. (2013). 'Iron Fist' Policies Feed Central America Gang Violence: Study. InsightCrime. 4. Cawley, M. (2013). Overcrowded CentAm Prisons Reflect Failed 'Iron Fist' Policies. InsightCrime. 12 Copyright 2013 SMU Economics Intelligence Club

5. Dudley, S. (2013). El Salvador's Gang Truce: Positives and Negatives. InSight Crime. 6. Nye, J. (2013). Inside El Salvador's secretive prison pits where notorious gangs are crammed together like livestock in cells the size of a shed. The Dailymail. 7. R.D. (2012). The Economics of Crime: Is Crime Rational?. The Economist.

13 Copyright 2012 SMU Economics Intelligence Club

The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large- cap common stocks actively traded in the United States. It has been widely regarded as a gauge for the large cap US equities market The MSCI Asia ex Japan Index is a free float-adjusted market capitalization index consisting of 10 developed and emerging market country indices: China, Hong Kong, India, Indonesia, Korea, Malaysia, Philippines, Singapore, Taiwan, and Thailand. The STOXX Europe 600 Index is regarded as a benchmark for European equity markets. It represents large, mid and small capitalization companies across 18 countries of the European region: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the United Kingdom.

Correspondents : Vera Soh (Vice President, Publication) vera.soh.2011@economics.smu.edu.sg Singapore Management University Singapore Samuel Ong (Publications Director/ Editor) samuel.ong.2010@business.smu.edu.sg Singapore Management University Singapore Ng Yongxiang (Marketing Director) yx.ng.2011@accountancy.smu.edu.sg Singapore Management University Singapore Cheng Hao (Writer) Postgraduate Lee Kong Chian School of Business Singapore Management University hao.cheng.2012@maf.smu.edu.sg Kamini Devi Naidu (Writer) Undergraduate School of Social Sciences Singapore Management University kaminid.2010@socsc.smu.edu.sg

Ng Jia Wei (Vice President, Operations) jiawei.ng.2012@economics.smu.edu.sg Singapore Management University Singapore Yingyu Zeng (Liaison Officer) yingyu.zeng.2010@economics.smu.edu.sg Singapore Management University Singapore Darren Goh Xian Yong (Editor) darren.goh.2010@business.smu.edu.sg Singapore Management University Singapore Koh Kang Liang (Writer) Undergraduate School of Economics Singapore Management University klkoh.2013@economics.smu.edu.sg

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